ISL244E

Macroeconomics
Problem Session-10
by
Research Assistant
Serkan Değirmenci
D202/16-17.04.2012
 Today
• BLANCHARD (2009), Macroeconomics
- Chapter 7: PUTTING ALL MARKETS TOGETHER: THE AS-
AD MODEL (btw pages: 157-183)
 Quick Check (QC): (1-4) (Page: 181)
 Dig Deeper (DD): (5-11) (Page: 181-183)
 Chapter-7-QC-1 (Page: 181)
1. Using the information in this chapter, label each of the following statements
true, false, or uncertain. Explain briefly.
a. The aggregate supply relation implies that an increase in output leads to a
decrease in the price level. False. (see page 159)
b. The aggregate demand relation slopes down because at a higher price level,
consumers wish to purchase fewer goods. False. The AD curve slopes down because an
increase in P leads to a fall in M/P, so the nominal interest rate increases, and I and Y fall.
(see page 161)
c. The natural level of output can be determined by looking at the aggregate supply
relation alone. True. (see page 158-160)
d. Expansionary monetary policy has no effect on the level of output in the short-
run. False. (see page 166-169)
e. In the absence of changes in fiscal or monetary policy, the economy will always
remain at the natural level of output. False.
f. The neutrality of money in the medium run does not mean that monetary policy
cannot or should not be used to affect output. True (see Page 169-The Neutrality of
Money)
g. In the short-run, a reduction in the budget deficit decreases output and
decreases the interest rate. True (see Table 7-1)
 Chapter-7-QC-2 (Page: 181)
2. Supply shocks and the medium run (SIMILAR WITH SECTION 7.6)
Consider an economy with output equal to the natural level of output.
Now suppose there is an increase in unemployment benefits. (z )
a. Using the model developed in this chapter, show the effects of an
increase in unemployment benefits on the position of the AD and AS
curves in the short run and in the medium run.
b. How will the increase in unemployment benefits affect output and the
price level in the short run and in the medium run?
ANSWERS:
a. SR: short run WS: wage-setting curve
MR: medium run PS: price-setting curve

WS PS AS AD IS LM
SR up no up no no up
change change change
MR same as SR no up no no up
change further change change further
 Chapter-7-QC-2 (Page: 181)
2.b. Y i P
SR falls rises rises

MR falls rises further rises

further further
 Chapter-7-QC-3 (Page: 181)
3. Spending shocks and the medium run
Suppose the economy begins with output equal to its natural level.
Then, there is a reduction in income taxes. (T )
a. Using the AS-AD model developed in this chapter, show the effects of
a reduction in income taxes on the position of the AD, AS, IS, and LM
curves in the medium run.
b. What happens to output, the interest rate, and the price level in the
medium run? What happens to consumption and investment in the
medium run?
ANSWERS:
a. IS shifts right, and LM shifts up. AD shifts right, and AS shifts
up.
b. Y returns to its unchanged natural level. The interest rate
and the price level increase.
 Chapter-7-QC-4 (Page: 181)
4. The neutrality of money (SEE SECTION 7.4)
a. In what sense is money neutral? How is monetary policy useful if money is neutral?
b. Fiscal policy, like monetary policy, cannot change the natural level of output. Why then
is monetary policy considered neutral but fiscal policy is not?
c. Discuss the statement “Because neither fiscal nor monetary policy can affect the
natural level of output, it follows that, in the medium run, the natural level of output is
independent of all government policies.”
ANSWERS:
a. Money is neutral in the sense that the nominal money supply has no effect on
output or the interest rate in the medium run. Output returns to its natural level.
The interest rate is determined by the position of the IS curve and the natural level
of output. Despite the neutrality of money in the medium run, an increase in the
money supply will increase output and reduce the interest rate in the short run.
Therefore, expansionary monetary policy can be used to speed up the economy's
return to the natural level of output when output is low.
b. In the medium run, fiscal policy affects the interest rate and investment, so fiscal
policy is not considered neutral.
c. False. Labor market policies, such as the degree of unemployment insurance, can
affect the natural level of output.
 Chapter-7-DD-5 (Page: 181)
5. The paradox of saving, one last time
In chapter problems at the end of Chapter 3 and 5, we examined the
paradox of saving in the short run, under different assumptions about
the response of investment to output and the interest rate. Here we
consider the issue one last time in the context of the AS-AD model.
Suppose the economy begins with output equal to its natural level. Then
there is a decrease in consumer confidence, as households attempt to
increase their saving for a given level of disposable income.
a. In AS-AD and IS-LM diagrams, show the effects of the decline in
consumer confidence in the short run and the medium run. Explain
why curves shift in your diagrams.
b. What happens to output, the interest rate, and the price level in the
short run? What happens to consumption, investment, and private
saving in the short run? Is it possible that the decline in consumer
confidence will actually lead to a fall in private saving in the short run?
c. Repeat part (b) for the medium run. Is there any paradox of saving in
the medium run?
 Chapter-7-DD-5 (Page: 181)
ANSWERS:
a. IS LM AD AS
SR left down left no change

MR same as SR down further same as SR down

b-c. Y i P
SR falls falls falls
MR back to original Yn falls further falls further

The short-run change in investment is ambiguous, because the interest rate falls, which
tends to increase investment, but output also falls, which tends to reduce investment. In
the medium run, investment must rise (as compared to its short-run and original levels),
because the interest rate falls but output returns to its original level.
Since the budget deficit does not change in this problem, the change in private saving
equals the change in investment. It is possible that private saving will fall in the short
run, but private saving must rise (above its short-run and original levels) in the medium
run.
 Chapter-7-DD-6 (Page: 182)
6. Suppose that the interest rate has no effect on investment.
a. Can you think of a situation in which this may happen?
b. What does this imply for the slope of the IS curve?
c. What does this imply for the slope of the LM curve?
d. What does this imply for the slope of the AD curve?
Continue to assume that the interest rate has no effect on investment.
Assume that the economy starts at the natural level of output. Suppose
there is a shock to the variable z, so that the AS curve shifts up.
e. What is the short-run effect on output and the price level? Explain in
words.
f. What happens to output and the price level over time? Explain in
words.
 Chapter-7-DD-6 (Page: 182)
ANSWERS:
a. Open answer. Firms may be so pessimistic about sales that they do
not want to borrow at any interest rate.
b. The IS curve is vertical; the interest rate does not affect equilibrium
output.
c. The LM curve is unaffected.
d. The AD curve is vertical; the price level does not affect equilibrium
output.
e. The increase in z reduces the natural level of output and shifts the
AS curve up. Since the AD curve is vertical, equilibrium output does not
change, but the price level increases. Note that output is above its
natural level.
f. Since Y>Yn, P>Pe. Therefore, Pe rises and the AS curve shifts up. In
fact, the AS curve shifts up forever, and the price level increases forever.
Output does not change; it remains above its natural level forever.
 Chapter-7-DD-7 (Page: 182)
7. You learned in problem 6 (on the liquidity trap) in Chapter 5 that money
demand becomes very flat at low interest rates. For this problem,
consider the money demand function to be horizontal at a zero nominal
interest rate.
a. Draw the LM curve. How does the slope of the curve change when
the interest rate rises above zero?
b. Draw the IS curve. Does the shape of the curve change (necessarily)
when the interest rate falls below zero?
c. Draw the AD curve? (Hint: From the IS-LM diagram, think about the
price level at which the interest rate is zero. How does the AD curve
look above this price level? How does the AD curve look below this
price level?)
d. Draw the AD and AS curves and assume that equilibrium is at a point
where output is below the natural level of output and where the
interest rate is zero. Suppose the central bank increases the money
supply. What will be the effects on output in the short run and in the
medium run? Explain in words.
 Chapter-7-DD-7 (Page: 182)
a. The LM has a flat segment at i=0 and then slopes up.
b. The IS slopes down as before. There is no flat segment at
i=0. Arguably, the IS curve is undefined for nominal interest
rates below zero.
c. As P falls, M/P rises, and the nominal interest rate falls.
Eventually, when P falls far enough, the nominal interest reaches
zero. The AD curve slopes down until P reaches the level
consistent with i=0. For levels of P below this threshold, the AD
curve is vertical.
d. There is no effect on output in the short run or the medium
run. Since the money stock does not affect the interest rate, it
does not affect output.
 Chapter-7-DD-8 (Page: 182)
8. Supply shocks and demand management
Assume that the economy starts at the natural level of output. Now
ee pages
173-179 suppose there is an increase in the price of oil.
a. In an AS-AD diagram, show what happens to output and the price
ee pages level in the short run and in the medium run.
173-179
b. What happens to the unemployment rate in the short run? in the
medium run?
Suppose the Federal Reserve decides to respond immediately to the
increase in the price of oil. In particular, suppose that the Fed wants to
prevent the unemployment rate from changing in the short run, after
the increase in the price of oil. Assume that the Fed changes the
money supply once-immediately after the increase in the price of oil-
and then does not change the money supply again.
c. What should the Fed do to prevent the unemployment rate from
changing in the short run? Show how the Fed’s action, combined with
the increase in the price of oil, affects the AD-AS diagram in the short
run and the medium run.
 Chapter-7-DD-8 (Page: 182)
d. How do output and the price level in the short run and the medium
run compare to your answers from part (a)?
e. How do the short run and medium run unemployment rates compare
to your answers from part (b)?
ANSWERS:
a. The AS curve shifts up in the short run and shifts up further in the medium
run. Output falls in the short run and falls further in the medium run. The price
level rises in the short run and rises further in the medium run.
b. The unemployment rate rises in the short run and rises further in the
medium run.
c. The Fed could increase the money supply in the short run and shift the AD
curve to the right. The AS curve would shift up over time.
d. Output and the price level are higher in the short run in part (c). Output is
the same in the medium run in parts (a) and (c), but the price level is higher in
part (c).
e. The unemployment rate in the short run is lower in part (c), but the same in
the medium run in parts (a) and (c).
 Chapter-7-DD-9 (Page: 182)
9. Demand shocks and demand management
Assume that the economy starts at the natural level of output. Now
suppose there is a decline in business confidence, so that investment
demand falls for any interest rate.
a. In an AD-AS diagram, show what happens to output and the price
level in the short run and the medium run.
b. What happens to the unemployment rate in the short run? in the
medium run?
ANSWERS:
a. The AD curve shifts left in the short run. Output and the price level fall
in the short run.
In the medium run, the expected price level falls, and AS shifts down,
returning the economy to the original natural level of output, but at a
lower price level.
b. The unemployment rate rises in the short run, but returns to its original
level (the natural rate, which is unchanged) in the medium run.
 Chapter-7-DD-9 (Page: 182)
Suppose the Federal Reserve decides to respond immediately to the decline in
business confidence in the short run. In particular, suppose that the Fed wants to
prevent the unemployment rate from changing in the short run, after the decline
in business confidence.
c. What should the Fed do? Show how the Fed’s action, combined with the decline
in business confidence, affects the AD-AS diagram in the short run and the medium
run.
d. How do short run output and the short run price level compare to your answers
from part (a)?
e. How do the short run and medium run unemployment rates compare to your
answers from part (b)?
ANSWERS:
c. The Fed should increase the money supply, which shifts the AD curve right. A
monetary expansion of the proper size exactly offsets the effect of the decline in
business confidence on the AD curve. The net effect is that the AD curve does not
move in the short run or medium run, and neither does the AS curve.
d. Under the policy option in part (c), output and the price level are higher in the
short run. In the medium run, output is the same in parts (a) and (c), but the price
level is higher in part (c).
e. The unemployment rate is lower in the short run in part (c). In the medium run,
the unemployment rate is the same in parts (b) and (c).
 Chapter-7-DD-10 (Page: 182)
10. Based on your answers to problems 8 and 9 and the material from the
chapter, comment on the following statement:
The Federal Reserve has the easiest job in the world. All it has to do is
conduct expansionary monetary policy when the unemployment rate
increases and contractionary monetary policy when the
unemployment rate falls.
ANSWER:
The Fed’s job is not so easy. It has to distinguish changes in the actual rate
of unemployment from changes in the natural rate of unemployment.
The Fed can use monetary policy to keep the unemployment rate near the
natural rate, but it cannot affect the natural rate.
 Chapter-7-DD-11 (Page: 182)
11. Taxes, oil prices, and workers
Everyone in the labor force is concerned with two things: whether they
have a job and, if so, their after-tax income from the job (i.e., their
after-tax real wage). An unemployed worker may also be concerned
with the availability and amount of unemployment benefits, but we
will leave that issue aside for this problem.
a. Suppose there is an increase in oil prices. How will this affect the
unemployment rate in the short run and the medium run? How about
the real wage (W/P)? (see page 175 and 176)
b. Suppose there is reduction in income taxes. How will this affect the
unemployment rate in the short run and the medium run? How about
the real wage? For a given worker, how will after-tax income be
affected?
c. According to our model, what policy tools does the government have
available to increase the real wage?
 Chapter-7-DD-11 (Page: 182)
d. During 2003 and 2004, oil prices increased more or less at the
same time that income taxes were reduced. A popular joke at the time
was that people could use their tax refunds to pay for the higher gas
prices. How do your answers to this problem make sense of this joke?
ANSWERS:
a. The unemployment rate rises in the short run and rises further in the medium
run. The real wage falls immediately to its new medium-run level.
b. The unemployment rate falls in the short run but returns to the original natural
rate in the medium run. The real wage is unaffected. However, after tax income rises.
c. In our model, the real wage depends only upon the markup. A fall in the
markup increases the real wage. Policy measures that improve product market
competition—for example, more vigorous anti-trust enforcement—could increase the
real wage.
d. The fall in income taxes tended to increase the after-tax real wage. The increase
in oil prices tended to reduce the after-tax real wage. Intuitively, the immediate effect
of an oil price increase is to reduce the real wage by increasing gas prices. Thus, the
increase in gas prices tends to absorb the extra after-tax income provided by the tax
cut.
to be continued…